Fraud and Fecklessness on Wall Street

The most obvious takeaway from the Goldman Sachs/Abacus scandal is that trusting Wall Street firms to act in their clients’ interests is a mug’s game. (Felix Salmon offers a clear explanation of the way Goldman seems to have misled just about everyone on the wrong side of the Abacus deal.) But the whole story is also important because it shows, in painful detail, the utter fecklessness of investors and financial institutions during the housing bubble.

The obvious way that investors in the Abacus deal were feckless was that they were making a massive bet on the crappiest part of the U.S. housing market at a time when the huge problems in subprime lending were already rising to the surface. Felix, in his searing and generally quite convincing refutation of Henry Blodget, tries to argue that investors buying mortgage-backed securities in early 2007 were not betting on housing prices, because the structure of the deal was supposed to guarantee that even if housing prices flattened, they wouldn’t lose their money. But this is far too generous to the investors. The economics of subprime lending, and of C.D.O.s, depended on the assumption that there wasn’t a housing bubble, and that therefore housing prices would not fall sharply. That was a speculative assumption, given the massive runup in housing prices between 1998 and 2006, and if you acted on it you were speculating, even if you described it to yourself by another name. If you were buying subprime C.D.O.s in early 2007, you were betting that the housing bubble wasn’t going to burst, even though in much of the country it already had. That was a dubious bet at best.

Still, one can explain that bet away as the inevitable product of bubble thinking: during bubbles, what in retrospect seems obviously ridiculous looks quite reasonable. What’s less explicable, and more troubling, is the way all the players in this deal in effect outsourced the responsibility for their own due diligence to others. On the macro level, of course, the investors accepted as a matter of course the idea that you could package together lots of mediocre securities—as you can see from the flipbook that was put together for the deal (pp. 55-56), the actual securities in the deal were generally only BBB-rated—and create a security that was virtually guaranteed not to default. While widely shared, this was an assumption that made absolutely no sense in the case of subprime C.D.O.s. Then, instead of looking at the fundamentals of the securities themselves, they simply assumed that they could rely on the credit ratings the ratings agencies bestowed, even though those agencies’ conflicts of interest were well-known. And they also implicitly assumed that they didn’t have to scrutinize the actual securities because ACA Capital—the asset manager—had done that for them. The result was that IKB, the German bank in this deal, bought $150 million of notes in this C.D.O. without, as far as one can tell, doing much, if any, fundamental analysis of the product, while ACA (the parent company of ACA Capital), insured the super-senior tranche of the C.D.O. for almost a billion dollars (all of which it lost), without, again, ever really looking at the underlying economics of the deal.

Then there’s ACA Capital, which helped market the C.D.O. by trumpeting its analytical expertise, even as it was effectively outsourcing the actual selection of the C.D.O.’s securities to John Paulson. (ACA Capital may have made the final call on which securities were included, but they were working from Paulson’s list.) Now, ACA Capital appears to have been completely misled—it thought Paulson was investing in the C.D.O., rather than planning to short it. But that doesn’t excuse its failure to do due diligence in putting together the C.D.O., particularly since its name was on the deal.

None of these failings—making reckless bets, outsourcing analysis, relying on unrealistic financial models—are unethical, in the way that Goldman’s were. And these were also incredibly common failings during the housing bubble. But it’s precisely the fact that these behaviors don’t seem shocking—that they just represent the way things were done—that’s so shocking. For years, sophisticated investors and big financial institutions, all run by very well-paid individuals, invested huge sums of money on the basis of a few pearls of folk wisdom (“housing prices never fall”) and the words of some highly conflicted players, like the ratings agencies. This was a recipe for disaster, and disaster was what we got.

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